Secondary transactions and co-investments are creating more potential to diversify alternatives portfolios.
Private equity is a key component of a diversified investment portfolio, offering the potential for higher returns than traditional asset classes with lower volatility.
Despite a challenging fundraising environment over the past few years and an overall slowdown in deal volume, general partners (GPs) remain eager to deploy capital. At the same time, as distributions have slowed, limited partners (LPs) are utilizing the secondary market to rebalance their private equity portfolios.
These dynamics have culminated in growing volumes of secondary and co-investment opportunities. However, accessing high-quality deals requires strong GP relationships and an industry reputation as a strategic partner.
The expanding private equity universe
Primary investments are investments in private equity funds managed by GPs. GPs raise capital from LPs and invest it into private companies, often across various sectors.
The current market environment has fueled significant growth in two additional types of private equity investments: secondary transactions and co-investments.
These investments offer unique and important benefits to investors:
Secondary transactions acquire existing interests (funds or assets) of a private equity portfolio, which are often a few years into their lifecycle at the time of investment. Secondary investments fall into two general categories:
- LP transactions are primary fund interests that an LP sells to manage its private equity allocation. These interests tend to be more diversified and account for the majority of secondary volume. They may be sold at a discount to fair value.
- GP-led transactions take place when the GP seeks to extend ownership of its highest-performing asset(s). GPs will offer existing investors the option to liquidate or invest in the continuation vehicle while also raising continuation capital from new investors. These secondaries are more concentrated than LP transactions as they invest directly in shares of a company or companies. GP-led secondaries tend to transact at or close to the underlying fair market value. This segment of the secondary market has grown rapidly over the past several years.
- Co-investments are made directly into a single company alongside a GP, which enables GPs to execute larger deals and form strategic partnerships with LPs. Typically, GPs offer co-investment opportunities to current and prospective LPs in their primary funds.
Both types of investments are broadening the opportunity set for investors.
Secondaries: Unique characteristics and benefits vs. primary investments
A typical private equity fund investment would require investor capital to be locked up for up to 10-12 years, from the initial capital commitment to the final distribution. The secondary market provides sellers with an avenue for liquidity in an inherently illiquid asset class, and buyers have the opportunity to acquire quality, more mature assets at an attractive entry point.
Secondary investments offer numerous benefits, including the potential to:
- Mitigate the J-curve effect: The typical cash flow pattern from a private equity fund over time is known as the “J-curve.” In the early years, an investor incurs capital calls, fees and start-up costs. Gains tend to be realized in the later years as value is created in the portfolio companies, investors receive distributions and the strategy begins to exit underlying investments. By buying into a more mature portfolio, investors are likely to see distributions much sooner than with a primary investment.
- Reduce blind pool risk: While primary investments are made when the fund is uncommitted, secondary investments are at least 40% identified, reducing the overall investment risk.
- Increase diversification: Particularly with LP transactions, investors can potentially gain immediate diversification across vintages, strategies and industries. Secondaries can also help investors build new GP relationships and gain exposure to hard-to-access GPs’ portfolios.
- Purchase shares at a discount: Secondaries can be purchased at a discount to fair market value, creating a gain on day one of the investment. Recently, buyers have been able to acquire high-quality assets at material discounts, creating a differentiated source of alpha in addition to the performance of the underlying assets.
The secondary market has attractive near- and long-term growth drivers. In the near term, many institutional investors are selling in the secondary market to alleviate the “denominator effect”—the situation where many LPs have found themselves overallocated to private equity due to declines in the value of their public market portfolios. This past year has also seen a significant slowdown in distributions, and selling private equity interests on the secondary market has created liquidity for LPs.
In the long term, secondary deal flow is expected to increase in line with the strong primary fundraising environment of the last decade, given that historically, primary fundraising has been a leading indicator of secondary transaction volume.1
Further, the secondary market has evolved from an outlet for distressed LPs to a widely-utilized portfolio management tool. LPs will continue to use secondaries as a way to rebalance their portfolios, further supporting transaction volume.
Co-investments: Targeted exposure and attractive risk/reward profile
GPs will typically seek out co-investors—often existing LPs—for specific, high-conviction investments where they need more capital. Co-investors should look for opportunities alongside a GP with a proven track record, specifically in the sectors that it invests in, and a well-honed value creation playbook. The opportunity set for co-investments is substantial, particularly in the small and mid-market.
Co-investments offer their own particular benefits, including:
- Targeted exposure: Co-investments provide direct exposure to a single company, presenting an opportunity to back a specific investment thesis and value creation plan and the potential for high returns. While this type of investment has no blind pool risk, the concentrated exposure presents a higher-risk investment. As a risk mitigant, co-investment opportunities generally skew towards less cyclical sectors, such as healthcare, business services and technology.
- Attractive economics: Many co-investments are executed on a no-fee, no-carry basis as an added incentive for co-investors. A large allocation to co-investments in a portfolio can help drive down the overall costs to end investors.
- Second layer of due diligence: While the GP provides its own independent evaluation of the company, an experienced and well-resourced co-investor is able to provide complementary due diligence analysis.
- Shorter J-curve: Most of the commitment for a co-investment is invested up-front (in some cases, a small percentage of capital is reserved for future add-on investments), shortening the J-curve to the holding period of the single investment.
Choosing the right partner is critical
While the opportunity in both secondaries and co-investments is compelling, the market has become increasingly competitive and is not easy to navigate. An experienced partner with strong GP relationships, a robust due diligence process and a proven track record is essential in order to access:
- High-quality deals: Longstanding partnerships with experienced GPs may lead to preferential access for both GP-led and LP secondary deals, and co-investments. GPs often have restrictive LP lists and tend to prefer investors with primary investment capabilities that can support future fundraises. For co-investments, GPs, especially those focused on the small and mid-market, look for capable strategic partners, not simply capital providers. A pre-existing relationship can also help investors negotiate favorable terms.
- Market insight and intelligence: Intermediaries, such as investment banks and placement agents, are another crucial source of secondary transaction volume. Intermediaries run the entire process on behalf of the seller and play an important role throughout a secondary transaction lifecycle, which is characterized by limited information availability and tight timelines. Intermediaries can provide secondary buyers with intelligence on potential future and off-market opportunities and help them negotiate more favorable terms and pricing. In turn, the intermediary learns about the types of transactions that would be most attractive to the buyer for future deal flow.
- Robust and efficient due diligence: Lastly and most importantly, secondary transactions and co-investments require robust due diligence processes. Buyers must be able to appropriately value the portfolio of assets and determine whether the price is fair given the projected upside, as well as the potential risks. Co-investments require even greater scrutiny due to the degree of exposure to one company and the additional layer of manager due diligence.
To learn more about how private equity is managed and how individual investors can access private equity, see Essentials of private equity investing and A simplified way to access private equity.
About the J.P. Morgan Private Equity Group
J.P. Morgan is a global leader in investment management with $2.8 trillion in assets under management (as of 6/30/23) across equities, fixed income, liquidity and alternatives. Led by a global team of over 60 professionals operating from New York, London, Hong Kong and Mumbai, the J.P. Morgan Private Equity Group (PEG) manages $30 billion of assets on behalf of a diverse group of leading institutions and individual investors. Founded in 1980, PEG is one of the longest-standing platforms in the industry. Over the past 40+ years, PEG has cultivated a deep network of general partner (GP) relationships and sits on over 200 advisory boards. PEG’s collaborative partnerships with top-tier GPs and continued participation in primary investments also make it a preferred strategic partner for co-investment and secondary opportunities.